EU regulatory action on performance fees in retail funds
A&L Goodbody, Dublin
The European Securities and Markets Authority (ESMA) has trained the regulatory spotlight on the charging of performance fees and retail funds. It has published guidelines for European regulators on requirements for performance fees in both Undertaking for Collective Investment in Transferable Securities funds (UCITS) and retail alternative investment funds (AIFs). Its stated goal is to harmonise European Union supervisory practices in the area and it marks a further step for the ESMA as it endeavours to harmonise rules across retail AIFs, which to date have been only subject to local rules in different jurisdictions in the EU.
This follows analysis and investigation of the charging of performance fees in UCITS funds by a number of EU regulators including the Central Bank of Ireland.
What funds are in scope?
UCITS funds are covered and the guidelines also apply to AIFs that are marketed to retail investors in the EU, with the exception of closed-ended AIFs, venture capital AIFs, European social enterprise funds, private equity AIFs and real estate AIFs.
Many European regulators have published requirements for the charging of performance fees in UCITS funds; some also have them for retail AIFs that they regulate. However, the ESMA guidelines will introduce new requirements for managers.
What are the guidelines?
The first guideline calls for a calculation methodology that is verifiable and is not open to manipulation by the manager. Such methodology must include a reference indicator, being an index, a high-water mark, a hurdle rate or a combination of them; a crystallisation frequency; a performance reference period; a performance fee rate; a performance fee methodology; and a computation frequency that must align with the net asset value calculation frequency of the fund.
The second requires managers to implement and maintain a process of periodic review to ensure that the performance fee model remains consistent with the fund's investment objectives, strategy and policy.
The third deals with the frequency of crystallisation and subsequent payment of the performance fee. The ESMA has mandated that the crystallisation frequency may not be any more frequent than once a year. There are certain exceptions to this requirement where the performance reference period is the whole life of the fund or a fulcrum fee model is used.
The fourth requires that any previous underperformance to be recovered before a performance fee becomes payable. However, it does allow for resetting of high-water marks, which will be new in certain jurisdictions, such as Ireland. However, any underperformance in the previous five years must always be recovered.
The fifth deals with information provided to investors in the fund’s prospectus, marketing material, key investor information document and financial statements. It also calls for a worked example to be included in the prospectus, which will be a new requirement in certain jurisdictions.
When are the guidelines effective?
The guidelines will apply from two months after their publication in all EU official languages on the ESMA website. As of 25 May 2020, this had yet to happen. Within the two-month period, each EU regulator is obliged to state whether they will apply the guidelines and, if not, why not. It is likely that EU regulators will apply the guidelines. The guidelines will then apply to any new fund authorised after that effective date and for any existing funds that introduce a performance fee after the effective date. Managers of existing funds that have performance fees in place must make any amendments necessary to comply with the guidelines by the beginning of their next financial year after six months from the effective date. So, for existing funds with a 31 December year end, we would expect the guidelines to be effective from 1 January 2022.
Conclusion – what will the impact be?
The guidelines will not change a lot for UCITs funds. Funds will need to update disclosure, some may need to ensure that the performance period is no greater than a year and many will welcome the ability to reset a high-water mark.
For retail AIFs, the regulatory landscape already varies quite a bit across Europe and so some managers may find themselves having to make quite significant changes to performance fee provisions in fund documentation to bring them in line with the guidelines.
European Securities and Markets Authority, Final Report: Guidelines on performance fees in UCITS and certain types of AIFs (3 April 2020), www.esma.europa.eu/sites/default/files/library/esma_34-39-968_final_report_guidelines_on_performance_fees.pdf